Will the Last Startup Leaving Dodd's America Please Turn Off the Lights?

This takes an area that has been defined by certainty and by a liberal view of what it takes to be "accredited" - no small benefit for the rise of startups over the past 30 years - and, in my view, gratuitously places a big question mark over it. You can take a sanguine view of what this means. I choose not to. Only time will tell which of us has the right instincts about it.

For the benefit of the startups I represent, I sincerely hope that you are right and I am wrong.

I must confess that some of my comments were indeed superficial but I did want to explain briefly why I have the perspective that I do. It is perhaps as much philosophical as anything else.

In this area, there has always been a continual tension between protecting investors (the very purpose of the securities laws) and giving people freedom to invest freely in ways that promote capital formation.

The Securities Act of 1933 imposes registration requirements upon the issuers of securities. The basic idea is that stock (and other securities) can be sold to the public only when accompanied by suitable disclosure materials such that a prospective investor can have a good understanding of the risks associated with the investment. Each state also has its own version of such laws, and these are known as "blue sky" laws. Thus, any issuer that desires to sell stock to public investors must register it with the SEC and also comply with the parallel blue-sky requirements.

Section 4(2) of the 1933 Act provides an exemption from these registration requirements for private placements. This is required for small-company capital formation because such companies would choke on the compliance costs involved with registration and, more importantly, in a private placement, the problems associated with selling stock to mass numbers of small and often unsophisticated public purchasers are just not present and it is overkill to apply the full force of the registration requirements to such situations.

The question is what is a "private placement"? Before Regulation D was adopted in 1982, this whole area was a mess. Did an offering to 5 people constitute a public offering? Or to 10? Or to 20? How about if stock were sold to 5, then another 5, then another and another, and so on, all in succession? At what point did such offerings cease to be private placements and become "public" offerings and hence illegal unless accompanied by suitable SEC registration? What if stock were sold to 15 people but were done via public forms of advertising? Did that make a difference? What if the investors numbered 50 or 500 but were all sophisticated investors capable of understanding the nature of the investment? Did that make a difference? What if they were given audited financials and similar forms of disclosure as part of the offering?

All such questions went all over the board prior to the enactment of Regulation D as courts struggled to make sense of the meaning of Section 4(2), and the result was a proliferation of litigation all over the nation that could easily ensnare issuers and their principals with large legal expenses and possible large judgments. And the penalties were not small. A violation of the 1933 Act by an issuer that does an improper unregistered offering meant that investors could rescind their stock purchases out to 3 years after their purchase and, moreover, could get their money back not only from the issuers but also from the principals who controlled them.

I remember this vividly. I clerked for a federal judge in the 1979-1980 period and saw firsthand the kinds of crazy cases that could wind up in court over such issues.

And here is the key point about such litigation: it could take all shapes and sizes because of uncertainty surrounding the meaning of what constituted a private placement. In other words, a company that sought to issue stock in a private placement could never know for sure (except in really extreme cases) whether investors could come back to bite the company and its principals simply because the company wound up failing. This set up all sorts of situations where lawyers could second-guess the offering even a long time after the fact because they could always point to this or that fact or circumstances that they would argue took the offering out of the 4(2) exempt category and subjected it to registration requirements. This uncertainty made it risky for companies to attempt to raise capital via private placements and hindered such offerings accordingly.

Starting in 1982, Regulation D solved all this by bringing certainty to this process. It set out clear rules for what was or was not a private placement and it did so for various types of offerings, small and large. It did so by delineating "safe harbors" by which an issuer could know, if it met the rules, it would clearly be doing a private placement that could not be second-guessed after the fact. And, of course, by second-guessed, I mean that lawyers could not bring expensive proceedings against the company and its principals based on creative interpretations of facts and circumstances by which they would argue that an offering was not really a private placement (at least they were not likely to win such cases, and this deterred bringing them). Such issues were off the table so long as the rules of Regulation D were met.

The definition of an "accredited investor" was a key part of this because, with such investors (or at least with a predominance of them), the safe-harbor requirements could easily be met for any given offering.

Thus, in practice today, when I tell my clients to try to limit their offerings to accredited investors, I can know as a lawyer that they are on relatively safe ground in how they handle their offering. It is easy to structure such offerings without undue legal risk and hence such startups can much more easily raise capital for their ventures.

Now take that same scenario and shrink the number of accredited investors radically and the whole structure of Regulation D is compromised such that we are nowhere near as likely to have the certainty of "safe harbors" for issuers and their management but we instead have a much larger element of uncertainty and room for after-the-fact second-guessing if an investment goes bad.

If you have a startup and need to deal with large numbers of non-accredited investors (as newly and more restrictively defined), and your company goes south, it is simply much easier for investors to sue for alleged violations of the 1933 Act. This means they can sue not only the company but also its officers and directors. This means those who sit on boards face larger liability exposure. This means even VCs who invest in companies and get board sits run higher risks in subsequent offerings unless the investors are all accredited under the stricter definition. All in all, it means that capital formation efforts will be hindered as much of the activity now falls into the more uncertain category where lawyers can easily second guess.

This is the practical reality. And this is why I made my statements about this sort of bill effectively promoting the interests of the lawyers. Yes, you can say that it really protects investors and that is the purpose of the securities laws in the first place. But that was true as well of the legal landscape before Regulation D was enacted in 1982 and, though investors were theoretically protected, it also meant it was hard to raise capital without running an undue risk of potentially being devoured by lawsuits if things didn't go well with the investment. Thus, the Dodd bill signifies, for me, a move in the wrong direction, philosophically speaking. It is the same type of bent that would lead to further steps in the direction of removing "safe harbor" protections from issuers wanting to do offerings.

I don't think this is paranoid thinking. I am simply looking to the philosophy of the proponents of such changes. The state of affairs that I fear might happen as lawmakers go down this path is not something that is unheard of - after all, it did exist for over four decades prior to 1982. And it is Regulation D that altered this and that ushered in a great era of small-company capital formation.

Thus, the Dodd legislation, in giving the SEC an impetus to scale back who can be an "accredited investor," is effectively going to make this area more litigious and is going to hinder small-company capital formation activities accordingly. Maybe this is good. But laws can and do work counter-productively even if they are enacted in the name of protecting investors. Just think about what Sarbanes-Oxley did to the IPO market. The question here is what this signifies and whether it will lead to tightened laws relating to small-company formation that will make it much more difficult for startups to raise funding.

I believe that is why many of the VCs, angel groups, etc. are worried about the Dodd legislation. It is perhaps not so much in what it does as an immediate step but in what it signifies about the future of Regulation D and a strong system of small-company capital formation. No serious problems have arisen under the current system. Why tamper with it, then?

I think it is legitimate to raise questions about the motives of those who would seek to fix something that is not broken when the practical effect of such steps is to make the process much less certain and much more prone to litigation. Like I said, I hope I am wrong about the potential implications of this legislation but I worry about where it might head.

1. Under existing law, startup companies can raise money easily and quickly from "accredited investors." There is no need for the companies or the investors to gain approval from any state or regulatory official.

2. This would change if Section 926 of the Dodd bill is included in any final reform legislation. That section would require, for the first time, companies seeking angel investment to make a filing with the Securities and Exchange Commission, which would have 120 days to review it. This would both raise the cost of seeking angels and delay the ability of companies to benefit from their funding.

Remind me - did you complain when Dems did that to Bush? (Pre 2006)? You remember - "Disent is patriotic" and all that. Or is that somehow different?

Of cours, the Repubs actually do have proposals. You don't hear about them in the "tingly leg" media, so you'd have you'd have to look elsewhere. Or is that their fault too?

For example Enron had to work hard to fool all those accountants, and as a result one of the largest accounting companies in the world went under and many of its partners are still mired in lawsuits. The banks created a very convoluted system to mislead investors as to the value of their securities, which involved a lot of new legislation, somehow tricking or corrupting the ratings agencies, controlling markets, etc.

So scams happen, but they are not as easy. Of course I think securities laws could stand improvement.

But we do not have the case where there are so many scams on the stock market that everybody assumes that everything is a scam and nobody invests, so the stock market is essentially useless. This is the case for many (actually most) countries.

Second, to turn your argument on its head, why not get rid of the limits altogether? Let anyone invest in anything, whether or not the investment vehicle is registered with or reports to the SEC. Sounds great, right? Unfortunately, historical experience with this approach is that people get ripped off left, right and center, and taxpayers end up holding the bag.

True, taxpayers end up holding the bag for a lot of things anyway. I'm not sure how to fix this, but I'm pretty sure that removing all limits on the size of bags ain't it.